Does International Trade Stabilize Exchange Rate Volatility?

Ever since the early 1980s, major industrial countries have been suffering from severe multi-lateral trade imbalances, accompanied by tremendously volatile exchange rates. This paper examines the relationship between trade balance and exchange rate volatility. A stochastic macroeconomic model with sticky prices is developed. Our comparative statics and numerical simulation results indicate that an increased trade balance (relative to domestic aggregate demand) tends to reduce exchange rate volatility when the domestic absorption shock disturbs the economy. In the presence of all other domestic and foreign shocks, however, an increased trade balance tends to augment exchange-rate volatility, except for the case of a disturbance in domestic real income in which the effect of an increased trade balance is indeterminate. Our results suggest that whether trade imbalance has aggravated exchange rate volatility in many industrial countries is an open question, which needs to be solved through more empirical investigations.